Financing Enterprises (Custom Edition) - (Chapter 12 Money Banks and Interest Rates)

12 Money, Banks and Interest Rates
LEARNING OBJECTIVES After studying this chapter, you will be able to
Define the functions of money.

1 4 Explain the relationship between money and interest
rates and the role of various financial institutions in this
relationship.
List the factors that determine the amount of money in the
2 economy and what causes it to grow. Explain what the Explain how a change in the money supply affects the
role of banks is in this process. 5 level of aggregate demand and how this, in turn, will affect
the level of real GDP.
Explain why central banks, such as the Reserve Bank
3 of Australia, play a crucial role in the functioning of
economies.2
INTRODUCTION
In this chapter we are going to look at the important role that the banking system plays in
the economy. Changes in the behaviour of financial institutions and in the supply of money
can have a powerful effect on all the major macroeconomic indicators, such as inflation,
unemployment, economic growth, exchange rates and the balance of payments.
But why do changes in the money supply affect the economy? Well, the supply of
money and the demand for money between them determine the rate of interest, and this
has a crucial impact on aggregate demand and the performance of the economy generally.
But, more than this, many aspects of economic activity are dependent on the availability of
money.
The very first question addressed in this chapter is to define what is actually meant by
money (not as easy as it may seem) and to examine its functions. Then in Sections 12.2 and
12.3 we look at the operation of the financial sector of the economy and its role in determin-
ing the supply of money. This sector has come in for considerable scrutiny in recent times,
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following the banking turmoil associated with the ‘credit crunch’ of 2007–09.
We then turn to look at the demand for money. Here we are not asking how much
money people would like. The answer to that would probably be ‘as much as possible’! What
we are asking is: how much of people’s assets do they want to hold in the form of money?
Then, in Section 12.5, we put supply and demand together to show how interest rates
are determined, or how money supply must be manipulated to achieve a chosen rate of
interest. We will see how changes in money supply and/or interest rates affect aggregate
demand and the level of activity in the economy.
1 LEARNING OBJECTIVE 12.1 The Meaning and Functions of Money

Define the functions of money.
What is this thing called ‘money’?
Before going any further we must define precisely what we mean by ‘money’. Money is more
than just notes and coin. In fact, the main component of a country’s money supply is not
cash, but deposits in banks and other financial institutions. The bulk of the deposits appear
merely as bookkeeping entries in the banks’ accounts.
314
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Sloman, J., Norris, K., & Garrett, D. (2014). Principles of economics (4th ed.). Frenchs Forest, Australia: Pearson Australia.
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C H AP T ER 1 2 Money, Banks and Interest Rates 315
People can access and use the money in their accounts through B-pay, cheques,
debit cards and so on without using cash. Only a very small proportion of these deposits,
therefore, needs to be kept by banks in the form of cash.
What items should be included in the definition of money? To answer this we need to
identify the functions of money.
THE FUNCTIONS OF MONEY

The main purpose of money is for buying and selling goods, services and assets (i.e. as a
medium of exchange). It also has two other important functions. Let us examine each in turn.
A medium of exchange
In a subsistence economy where individuals make their own clothes, grow their own food, provide
their own entertainment and so on, people do not need money. If people want to exchange any
goods, they will do so by barter. In other words, they will swap goods with other people.
The complexities of a modern developed economy, however, make barter totally
impractical for most purposes. What is necessary is a medium of exchange that is generally medium of exchange Something
acceptable as a means of payment for goods and services and as a means of payment for that is acceptable in exchange for
labour and other factor services. ‘Money’ is such a medium. goods and services.
To be a suitable physical means of exchange, money must be light enough to carry
around, must come in a number of denominations, large and small, and must not be easy
to forge. Alternatively, money must be in a form that enables it to be transferred indirectly
through some acceptable mechanism. For example, money in the form of bookkeeping
entries in bank accounts can be transferred from one account to another by the use of such
mechanisms as cheques, keycards and direct debits.
A means of evaluation
Money allows the value of goods, services and assets to be compared. The value of goods is
expressed in terms of prices, and prices are expressed in monetary terms. Money also allows
dissimilar things, such as a person’s wealth or a company’s assets, to be added up. Similarly,
a country’s GDP is expressed in monetary terms. Money thus serves as a ‘unit of account’. PAUSE FOR THOUGHT
A means of storing wealth Why might money prices
People need a means whereby the fruits of today’s labour can be used to purchase goods give a poor indication of
and services in the future. People need to be able to store their wealth: they want a means of the value of goods and
saving. Money is one such medium in which to hold wealth. It can be saved. services?
WHAT SHOULD COUNT AS MONEY?

What items, then, should be included in the definition of money? Unfortunately, there is no PAUSE FOR THOUGHT
sharp borderline between money and non-money.
Are there any substitutes
Cash (notes and coin) obviously counts as money. It readily meets all the functions for money?
of money. Goods (refrigerators, cars and steaks) do not count as money. But what about
various financial assets such as bank and credit union accounts, bonds and shares? Do they
count as money? The answer is: it depends on how narrowly money is defined.
Countries thus use several different measures of money supply. All include cash, but they
vary according to what additional items are included. To understand their significance and
the ways in which money supply can be controlled, it is first necessary to look at the various
types of account in which money can be held and at the various financial institutions involved.
✍ Concept Check 12.1

1. Money’s main function is as a medium of exchange. In addition, it is a means of
evaluation and a means of storing wealth.
2. What counts as money depends on how narrowly it is defined. All definitions
include cash, but they vary according to the other financial assets included.
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316 CHAPTE R 12 Money, Banks and Interest Rates
2 LEARNING OBJECTIVE 12.2 The Financial System in Australia

List the factors that determine
Where do banks and other financial institutions fit in?
the amount of money in the
economy and what causes it to THE ROLE OF THE FINANCIAL SECTOR
grow. Explain what the role of
Many different types of institutions make up the financial sector. They are jointly known as
banks is in this process
financial intermediaries. They all have the common function of providing a link between
financial intermediaries The those who wish to lend and those who wish to borrow. In other words, they act as the mechan
general name for financial ism whereby the supply of funds is matched to the demand for funds (refer to Chapter 8 for
institutions (e.g. banks, credit more details about financial intermediaries).
unions) which serve to channel Financial intermediaries can be divided into two groups: banks and non-bank financial
funds from depositors to intermediaries (NBFIs). The major financial institutions are listed in Table 12.1.
borrowers. The banks are by far the largest group of financial institutions, accounting for 55.5%
of total assets. A large proportion of financial transactions take place between financial
institutions, notably between the banks and the other institutions.
TABLE 12.1 Australian financial institutions
ASSETS AT MARCH 2019

($ BILLION)
Banks 4404.8
Credit unions and Building societies 51.3
Money market corporations 30.3
Finance companies 184.9
Securitisers 141.2
Insurance companies 403.3
Superannuation funds 2319.3
Other managed funds 396.6
TOTAL 7931.7
Source: Reserve Bank of Australia
BANKS
Four banks—Australia and New Zealand Banking Group Ltd, Commonwealth Bank,
National Australia Bank and Westpac—account for around 74% of all bank assets.
Banks accept deposits and, as explained in Section 12.3, by making loans they create
credit. They offer a wide range of retail banking services and operate, with the Reserve Bank
of Australia, the payment system through which the banks’ debts with each other are settled
daily. Banks are also heavily involved in dealing, both on their own account and on behalf
of their customers, in the foreign exchange market.
Assets and liabilities
Liabilities. Most of the banks’ liabilities take the form of the accounts, or deposits, held
with banks by individuals, companies, universities and so on. There are three major types
of deposit. First, demand deposits—any deposits that can be withdrawn on demand by the
depositor without penalty. In the past, demand deposits did not pay any interest but aggres-
sive competition between banks has led to a number of interest-paying demand deposits.
Second, time deposits, which require notice of withdrawal. They pay a higher rate of inter-
est than demand deposits. The third type of bank deposit is Certificates of Deposit (CDs).
These are certificates issued by the banks to companies and other financial institutions for
large deposits of a fixed term (e.g. $1 million for three months). They can be sold from one
customer to another and hence they are relatively liquid to the depositor. The use of CDs
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Assets. The banks hold a small proportion of their assets in currency and hold deposits
with the Reserve Bank in the same way that the public holds deposits with the banks. The
great majority of the banks’ assets comprise loans to customers. These vary in liquidity
depending on whether they are short-term overdrafts, two- or three-year personal loans,
business loans, loans made in the form of 25-year mortgages and so on.
Liquidity and profitability
The balance between the various forms of liability and assets is influenced by three consid-
erations: profitability, liquidity and capital adequacy.
Profitability. Profits are made by lending out money at a higher rate than that paid to
depositors. The average interest rate received by banks on their assets is higher than that
paid by them.
Liquidity. The liquidity of an asset is the ease with which it can be converted into cash liquidity The ease by which an
without loss. Cash itself, by definition, is perfectly liquid. asset can be converted into cash
The notes and coins inside a bank plus a bank’s deposit account at the Reserve Bank are without loss.
called bank reserves. Bank reserves are highly liquid and can be lent on an overnight basis bank reserves The notes and coins
to other banks and financial institutions. Other assets are much less liquid. Loans to the inside a bank plus a bank’s deposit
general public or home loans can be redeemed by the banks only as each instalment is paid. account at the Reserve Bank.
Banks must always be able to meet the demands of their customers for withdrawals
of money. To do this, they must hold sufficient reserves or other assets that can be readily
turned into cash. In other words, banks must maintain sufficient liquidity.
The ratio of an institution’s liquid assets to total assets is known as its liquidity liquidity ratio The proportion of
ratio. For example, if a bank had $100 million of assets, of which $10 million were liquid a bank’s total assets held in liquid
and $90 million were illiquid, the bank would have a 10% liquidity ratio. If a financial form.
institution’s liquidity ratio is too high, it will make too little profit. If the ratio is too low,
there will be the risk that customers’ demands may not be able to be met: this would cause
a crisis of confidence and possible closure. Institutions thus have to make a judgment as to
what liquidity ratio is best—one that is neither too high nor too low.
Capital adequacy. Banks must have sufficient capital (i.e. funds) to cover losses if borrowers
default on payment. Capital adequacy is a measure of a bank’s capital relative to its assets,
where the assets are weighted according to the degree of risk. The more risky the assets, the
greater the amount of capital that will be required.
NON-BANK FINANCIAL INTERMEDIARIES

Various other institutions act as financial intermediaries (see also Table 12.1):
Building societies and credit unions. These raise funds mainly from the household sector
and, in turn, lend to the household sector.
Money market corporations. These are also known as merchant banks. They borrow from
and lend to companies in large units of money.
Finance companies. These raise funds from retail investors and in what is termed the
wholesale market. They lend to households and to small businesses.
Securitisers. These pool a range of assets (e.g. housing loans) and sell them to other financial
institutions.
Insurance companies. These companies raise funds from premiums and hold a range of
assets issued by other financial institutions.
Superannuation funds. These manage contributions from employers and employees. They
invest in a range of financial assets.
Refer to Chapter 8 for more details about non-bank financial intermediaries.
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THE RESERVE BANK OF AUSTRALIA

At the heart of the financial system of a country is the central bank. In Australia this is the
Reserve Bank. It has two main roles. The first is to oversee the whole monetary system and
ensure that banks and other financial institutions operate as stably and as efficiently as
possible. The second is to carry out monetary policy. Just how closely a central bank works
with the government in this second role will vary from country to country. In Australia the
Reserve Bank is independent of the government. The bank, through its Board, is respons
ible for monetary policy, notably the determination of interest rates. The government can,
of course, make its views known to the Board either in public or in private.
Within its two broad roles the Reserve Bank has several different functions.
Issue notes
The Reserve Bank is responsible for the printing and distribution of banknotes. The number
of banknotes on issue normally rises by about 5% a year, roughly in line with the annual
growth of nominal GDP. There was, however, a surge in the demand for banknotes at the
time of the global financial crisis at the end of 2008, when the value of banknotes in circula-
tion rose by nearly 20%.
Acts as a bank
The Reserve Bank is the bank of the government. It operates bank accounts for the federal
and state governments. If you receive a tax rebate by cheque, for example, the cheque will be
drawn on the Reserve Bank.
Also, the Reserve Bank is the banks’ bank. Commercial banks hold deposit accounts
with the Reserve Bank called exchange settlement balances and they use these to settle their
mutual debts.
Holds the official foreign currency reserves
Through buying and selling foreign currencies on the foreign exchange market, the Reserve
Bank can influence the exchange rate of the dollar.
Acts as a lender of last resort
PAUSE FOR THOUGHT
he Reserve Bank provides support to prevent banks getting into difficulties. It acts as
T
Could an economy a lender of last resort to banks (but not to non-bank financial intermediaries (NBFIs)).
function without a central Thus, it may avert financial disruption by making funds available to the banking system.
bank?
Operates monetary policy
This is a major function of the Reserve Bank. The Reserve Bank Act 1959 requires it to
operate its monetary policy in a way that will best achieve the following objectives:
• the stability of the currency of Australia
• the maintenance of full employment in Australia
• the economic prosperity and welfare of the people of Australia.
In recent years the view has emerged in official circles that the best way of achieving
PAUSE FOR THOUGHT these objectives is to maintain some degree of stability in the price level. In 1996 an exchange
of letters occurred between the Treasurer and the Governor of the Reserve Bank. It was
Will the Reserve Bank’s
monetary policy objectives
agreed that the Reserve Bank would operate monetary policy with the aim of keeping the
conflict with each other at inflation rate, over the economic cycle, in the range of 2–3%. The objectives and operation
times? of monetary policy are described in more detail in Chapter 13.

3. Financial intermediaries provide a link between borrowers and lenders. Collectively
the banks are the largest financial intermediaries, accounting for over a half of total
assets.
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4. Banks raise their money mainly by accepting deposits. There are three types of
deposits: demand deposits, time deposits and Certificates of Deposit.
5. Banks aim to make profits but they must also maintain sufficient liquidity. The
liquidity of an asset is the ease by which it can be turned into cash, without loss.
Liquid assets, however, tend to be unprofitable and profitable assets tend to be
illiquid. Banks therefore hold a range of assets of varying degrees of profitability
and liquidity.
6. Banks have to make decisions about how many assets to hold in liquid form.
The liquidity ratio of a bank measures its proportion of assets held in liquid form.
7. Banks are required to have a capital adequacy ratio (CAR) of at least 8%. A bank’s
CAR is the ratio of shareholders’ capital plus reserves to its risk-weighted assets.
8. The Reserve Bank of Australia is the central bank. It issues notes, acts as a banker
to the government and to banks, holds the official reserves of foreign currency and
is responsible for monetary policy.
12.3 The Supply of Money 3 LEARNING OBJECTIVE
Explain why central banks,

How is it measured and what determines its size? such as the Reserve Bank of
If money supply is to be monitored and possibly controlled, it is obviously necessary to Australia, play a crucial role in
measure it. But what should be included in the measure? Here we need to distinguish the functioning of economies.
between the monetary base and broad money.
The monetary base (or ‘high-powered money’) consists of cash (notes and coin) in monetary base Notes and coin
circulation outside the central bank, plus the deposits held by the banks at the Reserve outside the central bank, plus the
Bank. deposits held by the banks at the
But the monetary base gives us a very poor indication of the effective money supply, Reserve Bank.
since it excludes the most important source of liquidity for spending: bank deposits. The
problem is which deposits to include. We need to answer two questions:
• Should we include just current deposits or fixed deposits as well?
• Should we include just bank deposits or deposits with non-bank financial intermediaries
(NBFIs) as well?
Accordingly, there are several measures of the money supply and these are set out in
Table 12.2. There is no unique measure of the money supply. The distinctions between
different types of account have become blurred and it is increasingly easy to switch deposits broad money Cash in circulation
from one type of account to another. For these reasons, the most usual measure that plus bank deposits plus net
countries use for money supply is broad money, which in most cases includes all bank borrowings from the private sector
deposits and the liabilities (deposits) of NBFIs. by NBFIs.
TABLE 12.2 Alternative measures of the money supply, 2015
$ billion
Currency 61.3
Plus current deposits with banks 257.4
Equals M1 318.7
Plus other deposits with banks 1427.6
Equals M3 1746.3
Plus net borrowing from the private sector by NBFIs 1.2
Equals broad money 1747.5

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As we have seen, bank deposits in one form or another constitute by far the largest
component of (broad) money supply. To understand how the money supply expands and
contracts, and how it can be controlled, it is necessary to understand what determines
the size of bank deposits. Banks can themselves expand the amount of bank deposits and,
hence, the money supply by a process known as ‘credit creation’.
THE CREATION OF CREDIT

To illustrate this process in its simplest form, assume that banks have just one type of liabil-
ity—deposits. They hold just two types of asset—balances with the central bank (to achieve
liquidity) and loans to customers (to earn profit).
Banks want to achieve profitability while maintaining sufficient liquidity. Assume
that they believe that sufficient liquidity will be achieved if 10% of their assets are held as
balances with the central bank. The remaining 90% will then be in loans to customers. In
other words, the banks operate a 10% liquidity ratio.
Assume initially that the combined balance sheet of the banks is as shown in
Table 12.3. Total deposits are $100 billion, of which $10 billion (10%) are kept in balances
with the central bank. The remaining $90 billion (90%) are lent to customers.
TABLE 12.3 Banks’ original balance sheet
Assets $BN Liabilities $BN
Balances with the central bank 10 Deposits 100
Loans 90
Total 100 Total 100
Now assume that the government spends more money—$10 billion, say, on roads or
education. It pays for this with cheques drawn on its account with the central bank. The
people receiving the cheques deposit them in their banks. Banks return these cheques to
the central bank and their balances correspondingly increase by $10 billion. The combined
banks’ resulting balance sheet is shown in Table 12.4.
But this is not the end of the story. Banks now have surplus liquidity. With their
balances in the central bank having increased to $20 billion, they now have a liquidity ratio
of 20/110. If they are to return to a 10% liquidity ratio, they need only retain $11 billion as
balances at the central bank ($11 billion/$110 billion = 10%). The remaining $9 billion they
can lend to customers.
Assume now that customers spend this $9 billion in shops and the shopkeepers deposit
the cheques in their bank accounts. When the cheques are cleared, the balances in the central
bank of the customers’ banks will duly be debited by $9 billion, but the balances in the
central bank of the shopkeepers’ banks will be credited by $9 billion: leaving overall balances
in the central bank unaltered. There is still a surplus of $9 billion over what is required to
maintain the 10% liquidity ratio. The new deposits of $9 billion in the shopkeepers’ banks,
backed by balances in the central bank, can thus be used as the basis for further loans. A
total of 10% (i.e. $0.9 billion) must be kept back in the central bank, but the remaining
TABLE 12.4 The initial effect of an additional deposit of $10 billion
Balances with the central bank (old) 10 Deposits (old) 100
Balances with the central bank (new) 10 Deposits (new) 10
Loans 90
Total 110 Total 110
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90% (i.e. $8.1 billion) can be lent out again. When the money is spent and the cheques are
cleared, this $8.1 billion will still remain as surplus balances in the central bank and can
therefore be used as the basis for yet more loans. Again, 10% must be retained and the
remaining 90% can be lent out. This process goes on and on until eventually the position is
as shown in Table 12.5.
The initial increase in balances with the central bank of $10 billion has allowed banks
to create new advances (and hence deposits) of $90 billion, making a total increase in
monetary supply of $100 billion.
This effect is known as the bank multiplier. In this simple example, with a liquidity bank multiplier The number
ratio of 1⁄10 (i.e. 10%), the deposits multiplier is 10. An initial increase in deposits of of times greater the expansion
$10 billion allowed total deposits to rise by $100 billion. In this simple world, therefore, the of bank deposits is than the
bank multiplier is the inverse of the liquidity ratio (L). additional liquidity in banks that
causes it: the multiplier is the
Bank multiplier = 1⁄L inverse of the liquidity ratio.
In practice, the creation of credit is not as simple as this. There are three main
complications. PAUSE FOR THOUGHT
Bank’s liquidity ratio may vary If banks choose to operate

Banks may choose a different liquidity ratio. At certain times, banks may decide that it is a 10% liquidity ratio
prudent to hold a larger proportion of liquid assets. If Christmas and the summer holidays and receive extra cash
deposits of $10 million:
are approaching and people are likely to make bigger cash withdrawals, banks may decide
(a) How much credit will
to hold more liquid assets. They may also do so if they anticipate that their liquid assets may ultimately be created? (b)
soon be squeezed by government monetary policy. By how much will total
On the other hand, there may be an upsurge in consumer demand for credit. Banks deposits have expanded?
may be very keen to grant additional loans and thus make more profits, even though they (c) What is the size of the
have acquired no additional assets. They may simply go ahead and expand credit, and bank multiplier?
accept a lower liquidity ratio.
Customers may not want to take up the credit on offer. Banks may wish to make additional
loans, but customers may not want to borrow. There may be insufficient demand. But will
the banks not then lower their interest rates, thus encouraging people to borrow? Possibly;
but if they lower the rate they charge to borrowers, they must also lower the rate they pay to
depositors. But then depositors may switch to other financial institutions.
Banks may not operate a simple liquidity ratio
The fact that banks hold a number of fairly liquid assets, such as money at call, bills of exchange
and Certificates of Deposit, makes it difficult to identify a simple liquidity ratio. If the banks
use extra cash to buy such liquid assets, can they then use these assets as the basis for creating
credit? It is largely up to banks’ judgments on their overall liquidity position.
Some of the extra cash may be withdrawn from the banks

If extra cash comes into the banking system and, as a result, extra deposits are created, part
of them may be held by the public as cash outside the banks. In other words, some of the
extra cash leaks out of the banking system. This will result in an overall money multiplier money multiplier The number
effect that is smaller than the full bank multiplier. of times greater the expansion
of money supply is than the
expansion of the monetary base
TABLE 12.5 The full effect of an additional deposit of $10 billion that caused it.
Balances with the central bank (old) 10 Deposits (old) 100
Balances with the central bank (new) 10 Deposits (new; initial) 10
Loans (old) 90 (new; subsequent) 90
Loans 90
Total 200 Total 200
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RELATIONSHIP BETWEEN MONEY SUPPLY AND RATE OF INTEREST

Simple monetary theory often assumes that the supply of money is totally independent of
interest rates. The money supply is ‘exogenous’. This is illustrated in Figure 12.1(a). The
supply of money is assumed to be determined by the central bank.
Some economists, however, argue that money supply is ‘endogenous’, with higher interest
rates leading to increases in the supply of money. This is illustrated in Figure 12.1(b). The
argument is that the supply of money is responding to the demand for money. If people
start borrowing more money, the resulting shortage of money in the banks will drive up
interest rates. But if banks have surplus liquidity or are prepared to operate with a lower
liquidity ratio, they will create extra credit in response to the increased demand and higher
interest rates: thus money supply has expanded.
FIGURE 12.1 The supply of money curve
Ms Ms
Rate of interest
Rate of interest
0 Quantity of money 0 Quantity of money

(a) Exogenous money supply (b) Endogenous money supply

9. Money supply can be defined in a number of ways, depending on which items are included. The most useful measure
is broad money, which includes cash in circulation plus all bank deposits and all borrowings by (or deposits with) non-
bank financial intermediaries (NBFIs).
10. Bank deposits expand through a process of credit creation. If banks’ liquid assets increase, they can be used as a
base for increasing loans. When the loans are redeposited in banks, they form the base for yet more loans and, thus,
a process of multiple credit expansion takes place. The ratio of the increase of money to an expansion of the liquidity
base is called the ‘bank multiplier’. It is the inverse of the liquidity ratio.
11. In practice, it is difficult to predict the precise amount by which money supply will expand if there is an increase in
banks’ liquidity. The reasons are that banks may choose to hold a different liquidity ratio; customers may not take up
all of the credit on offer; there may be no simple liquidity ratio, given the range of near money assets; and some of the
extra cash may leak away into extra cash holdings by the general public.
4 LEARNING OBJECTIVE 12.4 The Demand for Money

Explain the relationship between
How much money do we want to hold at any one time?
money and interest rates and
the role of various financial The demand for money refers to the desire to hold money: to keep your wealth in the form
institutions in this relationship of money, rather than spending it on goods and services or using it to purchase financial
assets such as bonds or shares. It is usual to distinguish three reasons why people want to
hold their assets in the form of money:
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The transactions motive. Since money is a medium of exchange, it is required for

PAUSE FOR THOUGHT
conducting transactions. But since people only receive money at intervals (e.g. fortnightly
or monthly) and not continuously, they require balances of money to be held in cash or in Will students receiving an
current accounts. allowance who are paid
once a semester have a
The precautionary motive. Unforeseen circumstances can arise, such as a car breakdown, so
high or a low transactions
individuals often hold some additional money as a precaution. Firms, too, keep precaution- demand for money relative
ary balances because of uncertainties about the timing of their receipts and payments. If a to their income?
large customer is late in making payment, a firm may be unable to pay its suppliers unless
it has spare liquidity.
The assets motive. Money is not just a medium of exchange, but also a means of storing
wealth (see page 304). Keeping some or all of your wealth as money in a bank account has
the advantage of carrying no risk. It earns a relatively small, but safe, rate of return. Some
assets, such as company shares or bonds, may earn you more on average, but there is a
chance that their price will fall. In other words, they are risky.
WHAT DETERMINES THE SIZE OF THE DEMAND FOR MONEY?

We now examine the various determinants of the size of the demand for money (MD). In
particular, we look at the role of the rate of interest. First, however, let us identify the other
determinants of the demand for money.
Nominal GDP. The more money people earn, the greater will be their expenditure and
hence the greater the transactions demand for money. A rise in money incomes in a country
can be caused either by a rise in real GDP (i.e. real output) or by a rise in prices, or some
combination of the two.
The frequency with which people are paid. The less frequently people are paid, the greater
the level of money balances that will be required to tide them over until the next payment.
Financial innovations. The increased use of credit cards, debit cards and cash machines,
plus the advent of interest-paying current (demand) accounts, have resulted in changes in
the demand for money. The use of credit cards reduces both the transactions and precaution-
ary demands. Paying once a month for goods requires less money on average than paying
separately for each item purchased. Moreover, the possession of a credit card reduces or even
eliminates the need to hold precautionary balances for many people. On the other hand,
the increased availability of cash machines, the convenience of debit cards and the ability to
earn interest on current accounts have all encouraged people to hold more money in bank
accounts. The net effect has been an increase in the demand for money.
Speculation about future returns on assets. The assets motive for holding money depends
on people’s expectations. If they believe that share prices are about to fall on the stock
market, they will sell shares and hold larger balances of money in the meantime. The assets
demand, therefore, can be quite high when the price of securities is considered certain to
fall. Some clever (or lucky) individuals anticipated the 2008–09 stock market decline. They
sold shares and ‘went liquid’.
Generally, the more risky such alternatives to money become, the more people will PAUSE FOR THOUGHT
want to hold their assets as money balances in a bank or credit union.
People also speculate about changes in the exchange rate. If businesses believe that Which way is the demand
the exchange rate is about to appreciate (rise), they will hold greater balances of domestic for money curve likely
currency in the meantime, hoping to buy foreign currencies with them when the rate has to shift in each of the
risen (since they will then get more foreign currency for their money). following cases? (a) Prices
rise, but real incomes
The rate of interest. In terms of the operation of money markets, this is the most important stay the same. (b) Interest
determinant. It is related to the opportunity cost of holding money. The opportunity cost rates abroad rise relative
is the interest forgone by not holding higher interest-bearing assets, such as shares, bills or to domestic interest rates.
bonds. Generally, if rates of interest rise, they will rise more on shares, bills and bonds than (c) People anticipate that
on bank accounts. The demand for money will fall. The demand for money is thus inversely share prices are likely to
fall in the near future.
related to the rate of interest.
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The demand for money curve

The demand for money curve (MD) with respect to interest rates is shown in Figure 12.2. It
is downward sloping, showing that lower interest rates will encourage people to hold addi-
tional money balances.
A change in interest rates is shown by a movement along the demand for
money curve. A change in any other determinant of the demand for money (such as GDP
or expectations about exchange rate movements) will cause the whole curve to shift: a
rightward shift represents an increase in demand; a leftward shift represents a decrease.
FIGURE 12.2 The demand for money curve
Rate of interest
MD
0 Quantity of money

12. Three motives for holding money are the transactions, precautionary and assets
motives.
13. The demand for money will be higher (a) the higher the level of nominal GDP
(i.e. the higher the level of real GDP and the higher the price level); (b) the less
frequently people are paid; (c) the greater the advantages of holding money in bank
accounts, such as access to cash machines and the use of debit cards; (d) the
more risky alternative assets become and the more likely they are to fall in value,
and the more likely the exchange rate is to rise; and (e) the lower the opportunity
cost of holding money in terms of interest forgone on alternative assets.
14. The demand for money curve with respect to interest rates is downward sloping.
5 LEARNING OBJECTIVE 12.5 Equilibrium

Explain how a change in the
What effect does the demand and supply of money have on interest rates?
money supply affects the level
of aggregate demand and how EQUILIBRIUM IN THE MONEY MARKET
this, in turn, will affect the level
of real GDP.
Equilibrium in the money market occurs when the demand for money (MD) is equal to the
supply of money (Ms). This equilibrium is achieved through changes in the rate of interest.
In Figure 12.3 the equilibrium rate of interest is re and the quantity of money supplied is
Me. If the rate of interest is above re, people will have money balances surplus to their needs.
They would use them to buy bond, shares and other assets. This would drive up the price of
these assets. But the price of assets is inversely related to interest rates. The higher the price
of an asset (such as a government bond), the less will be any given dollar interest payment as
a percentage of its price (e.g. $10 as a percentage of $100 is 10%, but as a percentage of $200
is only 5%). Thus, a higher price of assets will correspond to lower interest rates.
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FIGURE 12.3 Equilibrium in the money market
Ms
Rate of interest
re
MD
0 Me
Quantity of money
As the rate of interest falls, there will be an increase in the demand for money, especially
asset balances (a movement down along the demand for money curve). The interest rate
will go on falling until it reaches re. Equilibrium is then achieved.
Similarly, if the rate of interest is below re, people will have insufficient money balances.
They will sell securities, thus lowering their prices and raising the rate of interest until it
reaches re.
A shift in either the Ms or the MD curve will lead to a new equilibrium quantity of
money and rate of interest at the new intersection of the curves. For example, an increase
in the supply of money will cause the rate of interest to fall, whereas a fall in the supply of
money will cause the rate of interest to rise.
Figure 12.4 shows the effect of a decrease in the supply of money. To start with, the
demand for money is given by MD0 and the supply of money by MS0 and the equilibrium interest rate
is r0. Now the Reserve Bank wants to raise the interest rate to r1. It cannot simply dictate this. With
an unchanged money supply at this higher interest rate there would be an excess supply of money, b
– a. So, at the same time as it increases the interest rate, it decreases the money supply and the money
supply curve shifts to the left, to MS1.
FIGURE 12.4 Changing the interest rate

MS1 MS0
Rate of interest
r1 a b
r0
MD0
0
Quantity of money
THE FULL EFFECT OF CHANGES IN MONEY SUPPLY ON

INTEREST RATES
The effect of changes in the money supply on interest rates will in turn affect the level
of economic activity in the economy. Assume that there is a rise in money supply.
The sequence of events is as follows:
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• A rise in money supply will lead to a fall in the rate of interest: this is necessary to
restore equilibrium in the money market.
• The fall in the rate of interest will lead to a rise in investment and other forms of
expenditure, such as on consumer durable goods and housing, which is financed by
borrowing.
• The rise in investment and consumption will mean increased injections into the circu-
lar flow of income. The effect will be a rise in aggregate demand, a resulting rise in GDP
and possibly a rise in inflation too.
• These effects will be reinforced by international effects. The fall in the interest rate is
likely to cause the exchange rate to depreciate, as the return on Australian financial
assets will now be reduced relative to those offered by overseas financial assets. This
depreciation will increase exports and decrease imports.

15. Equilibrium in the money market is where the supply of money is equal to the
demand. Equilibrium is achieved through changes in the interest rate.
16. The interest rate mechanism works as follows: a rise in money supply causes
money supply to exceed money demand; thus interest rates fall, causing
investment expenditure on consumer durables and housing to rise, which causes a
multiplied rise in GDP.
17. The fall in the interest rate will cause the exchange rate to depreciate. This leads to
increased exports and decreased imports.
KEY TERMS
bank multiplier 321 liquidity ratio 317
bank reserves 317 medium of exchange 315
broad money 319 monetary base 319
financial intermediaries 316 money multiplier 321
liquidity 317
STUDY QUESTIONS
12-1. How successful in the last year has the Reserve Bank been (c) an increased use of credit cards.
in achieving its objectives? 12-6. What effects will the following have on the equilibrium
12-2. Why might the relationship between the demand for rate of interest? (Consider which way the demand and/or
money and the interest rate be an unstable one? supply curves of money shift.)
12-3. Imagine you earned $10 000 a month and spent it evenly (a) Banks find that they have a higher liquidity ratio than
over the month. What would be your average cash bal- they need.
ance? If the interest rate was 20% per year, how might you (b) There is a rise in incomes.
reduce your average cash holding while still spending all (c) There is a growing belief that interest rates will rise
your income? from their current level.
12-4. Why do banks hold a range of assets of varying degrees of 12-7. Trace through the effect of a fall in the supply of money
liquidity and profitability? on aggregate demand. What will determine the size of the
12-5. What effect would the following have upon the demand for effect?
money curve? 12-8. List the various interest rates charged by your bank or credit
(a) an increasing use of automatic teller machines. union. How would you explain the different interest rates?
(b) an increase in interest rates.
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PROBLEMS AND APPLICATIONS

1. Imagine that the banking system receives additional de- (d) By how much will total deposits (liabilities) eventually
posits of $100 million and that all the individual banks rise, assuming that none of the additional liquidity is
wish to retain their current liquidity ratio of 20%. held outside the banking sector?
(a) How much of the $100 million will banks choose to (e) What is the size of the bank multiplier?
lend out initially? (f) If one-half of any additional liquidity is held outside
(b) What will happen to banks’ liabilities when the money the banking sector, by how much less will deposits
that is lent out is spent and the recipients of it deposit have risen compared with (d) above?
it in their bank accounts? 2. Compile a list of the last four times the Reserve Bank
(c) How much of these latest deposits will be lent out by changed the cash rate and by how much. How much each
the banks? did the four major banks change their mortgage interest
rate in each case? How would you explain the mortgage
interest rate changes?
MULTIPLE-CHOICE QUESTIONS
1. A medium of exchange is: ❏❏ (c) How much cash do you wish you could have?
❏❏ (a) a standard unit that provides a consistent way of ❏❏ (d) What proportion of your financial assets do you
quoting prices. want to hold in non-interest-bearing forms?
❏❏ (b) what sellers generally accept and buyers generally 5. Banks can create money:
use to pay for goods and services. ❏❏ (a) by offering financial services, such as money
❏❏ (c) an asset that can be used to transport purchasing market accounts.
power from one period of time to another. ❏❏ (b) by printing additional currency notes.
❏❏ the ability to buy something today but defer pay-
(d) ❏❏ (c) by paying interest to their depositors.
ment to the future. ❏❏ (d) by making loans that result in additional deposits.
2. John received an income tax refund of $500 in August 6. If real GDP falls:
2012. He put the money in a drawer and spent it when he ❏❏ (a) the quantity of money demanded will fall.
went on holiday to Bali in July 2013. This is an example of ❏❏ (b) the interest rate will rise.
money serving as: ❏❏ (c) the demand for money curve will shift to the left.
❏❏ (a) an investment good. ❏❏ (d) none of the above will necessarily happen.
❏❏ (b) a store of value. 7. The quantity of money demanded increases as the interest
❏❏ (c) a unit of account. rate falls, because:
❏❏ (d) a medium of exchange. ❏❏ (a) people need more money for transactions.
3. Which of the following would shift the demand for money ❏❏ (b) the opportunity cost of holding money falls.
curve to the left? ❏❏ (c) people demand more financial assets.
❏❏ (a) a rise in interest rates. ❏❏ (d) the exchange rate will rise.
❏❏ (b) a rise in real GDP. 8. If the interest rate increases:
❏❏ (c) a decrease in the price level. ❏❏ (a) the demand for money curve will shift to the left.
❏❏ (d) a decrease in the money supply. ❏❏ (b) the supply of money curve will shift to the left.
4. When economists speak of the ‘demand for money’, which ❏❏ (c) the transactions motive will lead to people holding
of the following questions are they asking? more money.
❏❏ (a) How much income would you like to earn? ❏❏ (d) none of the above.
❏❏ (b) How much wealth would you like?
M12_9780655702252_CH12.indd 327 2/11/20 11:04 AM

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12 Money, Banks and Interest Rates

LEARNING OBJECTIVES After studying this chapter, you will be able to

Define the functions of money.

1 LEARNING OBJECTIVE 12.1 The Meaning and Functions of Money

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THE FUNCTIONS OF MONEY

WHAT SHOULD COUNT AS MONEY?

✍ Concept Check 12.1

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2 LEARNING OBJECTIVE 12.2 The Financial System in Australia

TABLE 12.1 Australian financial institutions

ASSETS AT MARCH 2019

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NON-BANK FINANCIAL INTERMEDIARIES

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THE RESERVE BANK OF AUSTRALIA

✍ Concept Check 12.2

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12.3 The Supply of Money 3 LEARNING OBJECTIVE

Explain why central banks,

TABLE 12.2 Alternative measures of the money supply, 2015

Plus current deposits with banks 257.4

Plus other deposits with banks 1427.6

Plus net borrowing from the private sector by NBFIs 1.2

Equals broad money 1747.5

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THE CREATION OF CREDIT

TABLE 12.3 Banks’ original balance sheet

Assets $BN Liabilities $BN

Balances with the central bank 10 Deposits 100

Total 100 Total 100

TABLE 12.4 The initial effect of an additional deposit of $10 billion

Assets $BN Liabilities $BN

Balances with the central bank (old) 10 Deposits (old) 100

Balances with the central bank (new) 10 Deposits (new) 10

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Bank’s liquidity ratio may vary If banks choose to operate

Some of the extra cash may be withdrawn from the banks

Assets $BN Liabilities $BN

Balances with the central bank (old) 10 Deposits (old) 100

Balances with the central bank (new) 10 Deposits (new; initial) 10

Loans (old) 90 (new; subsequent) 90

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RELATIONSHIP BETWEEN MONEY SUPPLY AND RATE OF INTEREST

FIGURE 12.1 The supply of money curve

0 Quantity of money 0 Quantity of money

✍ Concept Check 12.3

4 LEARNING OBJECTIVE 12.4 The Demand for Money

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The transactions motive. Since money is a medium of exchange, it is required for

WHAT DETERMINES THE SIZE OF THE DEMAND FOR MONEY?

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The demand for money curve

FIGURE 12.2 The demand for money curve

✍ Concept Check 12.4

5 LEARNING OBJECTIVE 12.5 Equilibrium

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FIGURE 12.3 Equilibrium in the money market

FIGURE 12.4 Changing the interest rate